How to Short Munis

Thirty one states, their unemployment-insurance funds empty, have borrowed
nearly $41 billion from the federal government. California alone has borrowed
nearly $8.8 billion as of mid-November, according to the Labor Department.
As states try to replenish the funds and begin to repay the loans, employers
are facing increases in both state and federal payroll taxes, a potential
barrier to new hiring.

"Employers were hit with these adjustments quite a bit last year," said
Richard Hobbie, executive director for the National Association of State
Workforce Agencies. A National Employment Law Project analysis found 41 states
increased unemployment-insurance payroll taxes this year by an average of
nearly 33.9%. The largest was a 168.5% boost from 2009 in Hawaii.

States in the Red

Most states have addressed or still face gaps in their budgets, while tax
revenue declined.

Payroll taxes levied by states fund unemployment benefits for up to 26 weeks
-- and longer in some states. The federal government requires states to pay
benefits even if their unemployment funds run out of cash. As in past periods
of high joblessness, the federal government has paid for extended unemployment
benefits, this time for as long as 99 weeks.

The unemployment-compensation system, initiated during the Great Depression,
was designed so most states build reserves when jobs are plentiful and few
workers are receiving benefits, and then draw down the reserves in bad times.
But few states were prepared for a recession as deep and lasting as the recent
one, with unemployment remaining at a historically high 9.6% a year after
the economy resumed growing.

During the 2008-09 fiscal year, states collected $31 billion of unemployment-insurance
taxes and spent $79.4 billion on jobless benefits. Taxes are typically levied
on a per-worker basis.

Arizona, which owed the federal government $172.8 million as of mid-November,
increased its tax on employers by more than 50% at the beginning of this
year to an average of $145.60 a year per employee. "The dilemma we face is,
how do you do that without hurting the economic recovery we all hope is coming?" said
Steve Meissner, communications director for the Arizona Department of Economic
Security.

Indiana Gov. Mitch Daniels proposed cutting unemployment benefits earlier
this month despite his state's 10.1% unemployment rate. Indiana has borrowed
nearly $1.9 billion from the federal government to shore up its unemployment-compensation
fund; next year, the state is to begin taxing businesses more to replenish
the coffers.

Federal loans to states have so far been interest-free under a provision
in the Obama administration's 2009 fiscal-stimulus law. But that waiver expires
in January.

Texas, which has borrowed nearly $1.6 billion from the federal government
and raised employer taxes, is offering $1.1 billion in tax-exempt bonds to
repay loans before Washington begins imposing interest charges because, said
Ann Hatchitt, a spokeswoman for the Texas Workforce Commission. The state,
which employed the same strategy in the early 2000s recession, figures it
will pay investors less than it has to pay the federal government.

Time To Short Muni Bonds?

This looks a lot like the bailout that Ireland just got from the EU and IMF.
But Ireland's troubles are front page news while California, Arizona and New
York get their bailouts under the radar via already-existing programs like
unemployment benefit extensions and Build America Bond subsidies. So the true
magnitude of the state financial crisis is buried in hard-to-decipher Treasury
Department line items. When and if someone adds it all up, the number will
be shocking.

Perhaps in anticipation, munis got whacked last week, and now
yield more than not just Treasury bonds, but some taxable corporate
bonds. So munis might finally be interesting short candidates. Here are
some ways to bet against them:

Muni ETFs and closed-end funds
Both ETFs and closed funds theoretically can be shorted like stocks. These
days the "theoretically" is key, because finding shares to borrow and sell
is no longer a given. But if the shares are available, shorting these funds
is a fast, simple way to get broad short exposure. This strategy has a cost,
however, since closed-end muni funds and ETFs pay dividends that a short
seller must cover.

Muni credit default swaps
The hedge funds that made a killing on the housing bust did so mostly by buying
credit default swaps (insurance that pays off in the event a bond defaults)
on mortgage-backed bonds. Tthe muni version is available via the MCDX, an
index containing 50 equally-weighted credit default swaps for major muni
issuers.

Bond insurers
The insurance companies that guarantee the interest on less-than-stellar munis
are on the hook if defaults exceed historical levels. AMBAC just filed for
bankruptcy, leaving MBIA, Assured Guaranty, and Berkshire Hathaway as potential
shorts.

Owners and underwriters
According to the Federal Reserve, commercial lenders have been steadily increasing
their muni holdings in recent years, and now own bonds worth about $215 billion.
The muni portfolios of Citigroup, State Street, and U.S. Bancorp, for instance,
rose to 25-year highs in the first quarter. Several major banks, including
Bank of America, Citigroup, and Barclays are also underwriters of munis.

Insurance companies, meanwhile, reportedly own about $450 billion of munis,
with Travelers and American International Group owning $41 billion and $45
billion, respectively.

John Rubino is author of Clean Money: Picking Winners
in the Green Tech Boom (Wiley, December 2008), co-author, with GoldMoney's
James Turk, of The Collapse of the Dollar and How to Profit From It (Doubleday,
January 2008), and author of How to Profit from the Coming Real Estate
Bust (Rodale, 2003). After earning a Finance MBA from New York University,
he spent the 1980s on Wall Street, as a currency trader, equity analyst and
junk bond analyst. During the 1990s he was a featured columnist with TheStreet.com and
a frequent contributor to Individual Investor, Online Investor,
and Consumers Digest, among many other publications. He now writes
for CFA Magazine and edits DollarCollapse.com and GreenStockInvesting.com.